How Wall Street Is Like A Game of High-Stakes Poker

[Welcome, Physician on Fire readers! This article was featured in the 4/9/17 edition of The Sunday Best. If you’re new to the WSP community, I encourage you to start here! -WSP].

I love a good game of poker. I fondly remember the evening poker games I played in college. I even went to the local casino several times during college, making a few dollars at the low-stakes limit hold’em tables. I would consider myself an intermediate-level poker player, having read a few books about the game. I’m good enough to beat beginners, but you certainly won’t be seeing me on ESPN at the World Series Of Poker.

My enjoyment of poker probably contributed to me taking a job as a trader on Wall Street after college rather than heading straight to medical school. With millions, if not billions of dollars changing hands daily, is Wall Street not the largest, highest-stakes poker game in the world?

The stock market has millions of participants, and you don’t know any of the other players playing in the stock market. However, for some of the more exotic securities that are traded on Wall Street, there may be only 20-30 investors in a particular security. Along with the 25 or so investors, there might also be 5-10 investment banks who would make markets in that security. With such a small pool of investors where everyone knows everyone else, trading becomes a game of high-stakes poker. Success in trading in these markets are not about knowing the intrinsic value of these securities. Yes, there is much effort, both in academic and Wall Street circles, to value these securities. But it is more about playing your opponents than about playing your cards.

An excellent poker player will be able to sense weakness in their opponents, and bluff their way into winning their opponent’s chips, no matter what cards they hold. Similarly, if other traders sense that a competitor is weak, they will push the price against them, creating more losses, and eventually causing that competitor to capitulate and liquidate their investments at a fire-sale price.

The London Whale: A Case Study

One well-known case of this scenario was the London Whale case at J.P. Morgan in 2012. Bruno Iksil, a trader at J.P. Morgan, took a massive position in an obscure security called CDX IG9. His position was so large that it was distorting the market price of this security. Other traders, led by Boaz Weinsten at Saba Capital Management, figured out that Mr. Iksil was holding this large position and publicized the size of this position. In essence, the other hedge funds figured out what cards J.P. Morgan was holding.

Once that trading position began to go against J.P. Morgan, Saba and other hedge funds began to push the price against J.P. Morgan, creating larger and larger losses for the bank. Essentially, in response to Mr. Iksil’s large bet, other hedge funds raised him, pushing all their chips in the middle. Seeing paper losses in the billions of dollars, the upper management of J.P. Morgan commanded Mr. Iksil to liquidate his position. He was forced to sell the massive position at fire-sale prices, leading to a $6.2 billion loss. The hedge funds made J.P. Morgan fold, making billions of dollars in the process. Mr. Iksil potentially was on the eventual winning side of the trade, but he ran out of time and money.

There are many successful Wall Street traders who are also excellent poker players. The most famous one is David Einhorn of Greenlight Capital, who placed 18th at the World Series of Poker Main Event. There are a number of other Wall Street traders who have had success at the poker table. In many ways, the skills needed to be successful at trading translate to the poker table.

How Trading Is Like Poker

1. Fish and sharks: in poker parlance, the beginner players are called fish, who will lose their money to the sharks with more skill and experience. The sharks will eat the fish, and the professional players will take the money from the beginners. The same thing happens in trading.
2. Big players can move markets and push around weaker players: this was seen in the London Whale example. Mr. Iksil moved the market of this obscure security with his big position, but then the market moved against him when the hedge funds pushed back.
3. Thrill of big wins: The adrenaline rush when you win a big hand in poker can be addicting, and a similar rush occurs when you make a winning trade. In that sense, trading is like gambling, with all of its negative implications.
4. Controlling your emotions is key: Every trader will have winning days and losing days, and the key is to not trade emotionally when the market moves against you. You need to avoid going on tilt, a term used in poker when players get emotional after a losing hand and begin playing poorly.
5. The casino or the banks get their cut of your winnings: In poker, the casino takes a small percentage of each hand’s pot (called the rake). For example, if $50 are wagered in a given hand, the winning player will take $48 and the casino will keep $2. Similarly, there are several sources of trading costs. Trading costs include commissions, the bid-ask spread, and short-term capital gains taxes when trading in a taxable account. These costs can erode much of your investment returns.

Conclusion

Trading in the stock market is like playing in the highest-stakes poker game in the world. There are some very, very good players that you’re competing against, and most physicians will lose at this game. By investing instead in low-cost index funds, you stay out of the shark tank.

What do you think? Do you play poker? Do you think the skills in poker translate well to trading or investing?